Krugman’s New Cross Confirms It: Job Guarantee Policies Are Needed as Macroeconomic Stabilizers

By Daniel Negreiros ConceiçãoKrugman’s new explanation of business cycles in the form of a GSFB-PSFB (government sector financial balances – private sector financial balances) model (see his post entry here) has invoked a sort of call-to-arms by some dedicated Keynesian economists. Though those of us who have acquired the habit of looking at both sides of every nominal flow in the economy may see less novelty in Krugman’s new framework, the cross itself is still a very nice tool for presenting our arguments. And, if Krugman’s cross actually succeeds in replacing the unfortunate IS-LM interpretation of Keynes’ General Theory, it will have moved the New Keynesian approach in a constructive new direction.

I will not rehash the details of the Krugman cross in this post, since other bloggers have already explained the cross and some of its implications (see, e.g., Rob Parenteau’s, Scott Fullwiler’s, and Bill Mitchell’s). Instead, I want to draw out a particular (and potentially revolutionary) implication of the model.
I believe that what Krugman was able to finally see, with the help of his cross, is nothing but the restatement of Keynes’s old paradox of thrift for a closed economy with a government sector able to run a deficit (though one can also represent the original paradox of thrift taught in intermediate macroeconomics if the GSFB – government sector financial balances – curve coincides with the horizontal zero deficit/surplus line, i.e. if governments run a balanced budget). Much like the simple exposition of the paradox of thrift for a closed economy without a government sector where aggregate savings are unavoidably equal to the size of aggregate investments, in an economy with a government sector the value of the private sector surplus is unavoidably determined by the government deficit. This means that when the desired level of private sector surplus rises as a share of each level of GDP, the tautological stubbornness of the accounting identity forces the adjustment to take place in one of two ways (or a combination of both). Either:(1) The government deficit rises so that the private sector is able to achieve its new desired level of surplus at the current level of GDP


(2) GDP must fall until the GS (government sector) deficit reaches the new desired level of PS (private sector) surplus as a share of GDP

This is the exact equivalent to what Keynes argued with regard to an increase in the propensity to save. When people decide that they want to save more as a share of their incomes (or alternatively, when capitalists decide to increase the mark up over wage costs), for a given level of aggregate investment, aggregate incomes must fall so that the same aggregate savings becomes a greater share of the reduced aggregate income. As Rob Parenteau argued, “If Paul [Krugman] recalls his reading of Keynes’ General Theory (and he is to be applauded for being one of the few New Keynesians to actually read Keynes in the original), this is one of the reasons Keynes argues incomes adjust to close gaps between intended investment and planned saving.”

It is time to play a little with the shapes of the curves. Here I believe that Krugman’s analysis is especially useful for explaining policy prescriptions advanced by Post Keynesian economists. First of all, in the GSFB-PSFB model I see none of the interdependency problems and stock/flow inconsistencies that exist in the IS-LM model (so far…). As many of the bloggers (Felipe Rezende here) have demonstrated, under the current set of economic policies in the US, GS deficits tend to rise substantially when GDP falls also substantially. In Krugman’s framework this is represented as a relatively steep GSFB curve. The steeper the curve, the faster the deficit increases for a given reduction of GDP bellow a given threshold (given by the level of GDP where the GSFB curve intercepts the zero surplus/deficit horizontal axis). However, it is also true that the same government who responds promptly to a fall in GDP by raising its deficit significantly also responds aggressively to an increase in GDP above the threshold by raising its surplus since the curve is equally steep going down below the intercept as it is going up above it. Maybe we should represent the curve as having different steepness below and above the threshold, but this is less important as it depends on more sophisticated assumptions about government policies. While Prof. Krugman makes the interesting and convincing argument that the fact that today’s GSFB curve is much steeper than that of the early 1930s (meaning that GS deficits in the 30s did not rise significantly despite a great reduction in aggregate incomes) has kept us from experiencing another Great Depression, we have just begun to experiment with the shapes of the curve.

First of all, let us look at extreme situations:

(1) In the absence of government deficits or surpluses in the economy (i.e. if governments were blindly committed to having balanced budgets), the horizontal GSFB curve would coincide with the zero deficit/surplus line and changes in desired PS surplus out of savings would necessarily lead to aggregate income adjustments so that new equilibrium would be reached at the new intercept where PS surplus was zero. Income fluctuations would be the most violent under these conditions since changes in spending preferences by the private sector would lead to full income adjustments. Note that any horizontal GSFB curve would produce such effect. In other words, macroeconomic instability is the result not of the unwillingness of governments to run a deficit (indeed a horizontal GSFB curve above the horizontal axis could represent any size of GDP independent GS deficits), but of governments not adjusting the size of their deficits to changes in spending propensities out of given incomes.

(2) What if governments decided to determine the level of GDP for the economy (hopefully at full employment)? Then governments could accommodate any change in the level of desired PS surplus by raising and reducing its deficit accordingly so that GDP never needed to adjust. This would be represented by a vertical (or, more realistically, almost vertical if some GDP adjustments still took place) GSFB curve at full employment GDP. These are the kind of policies we should be looking for as automatic stabilizers: policies that make the GDFB as close to vertical as possible at full employment GDP. The most effective way to achieve it: an employer of last resort policy where changes in desired PS surplus at full employment GDP that lead to falling aggregate expenditures and employment in the private sector would be largely compensated by increases in government transfers to the newly hired workers in the form of wages. Even though it is not necessarily the case that the deficit brought about by such policy will be exactly equal to the new desired PS surplus at full employment GDP so that the GSFB is completely vertical, in addition to other stabilizers such policy will significantly raise the steepness of the curve.

Krugman has hit on something of great importance. I hope others will think through the implications of his approach and not allow the momentum to wane.

10 responses to “Krugman’s New Cross Confirms It: Job Guarantee Policies Are Needed as Macroeconomic Stabilizers

  1. I think the paradox of thrift connection is excellent, and absolutely fundamental. Krugman should be salivating over this.It’s worthwhile not to forget the role of the current account in this line of thinking. The domestic private sector can satisfy its net saving objective with government deficits and/or current account surpluses (i.e. capital account deficits) at the margin – i.e. reducing the current account deficit in today’s context. Both channels are currently operative.Indeed, the only slight hesitation I have with the use of the government-centric paradigm is that it is really the most prominent of what are two similar channels for the offset of desired domestic private sector net saving. The model always has to be qualified in this way, somehow, notwithstanding the awkward asymmetries involved.

  2. JKHI explicitly incorporated the current account into the graph in my post. Regardless, the ELR policy would still make the govt line in Krugman's model or the Gov Def + Cur Acct line in my post vertical, assuming you don't adhere first to some other constraint prior to attaining full employment, like a fixed exchange rate or a balanced budget. Daniel does a nice job of spelling out here the extreme cases that I alluded to at the end of that post and in my subsequent comments there.Best,Scott

  3. Dear Scott and JKH,Thank you for the helpful comments. I think that the GSFB-PSFB model has given us a nice tool to talk about economic policy. Both commentators are absolutely correct that a more realistic and useful model must represent an open economy. Hence, we must consider the current account balance as an additional source of instability (not as a policy instrument, though). In an open economy income instability may come from a reduction in the propensity to spend by agents out of each level of income domestically and abroad. Scott has brilliantly shown us how to add the trade balance to the GSFB-PSFB framework (making it a GSFB-PSFB-CAB – Current Account Balance). In the expanded model, equilibrium is reached at the point where the PS surplus (deficit) = [GS deficit (surplus) + trade surplus (deficit)]. We can find equilibrium at the level of GDP where our PSFB curve intercepts the GSFB+CAB curve. Naturally, it is also true that the GS deficit must equal the sum of the PS surplus plus the trade deficit. Hence, we can also find equilibrium GDP at the level where the combined curve (PSFB – CAB) intercepts the GSFB curve. I personally like finding equilibrium GDP like this for policy discussion purposes because it isolates the curve that can actually be controlled by policy most efficiently – i.e. the GSFB curve. Therefore, the goal for governments trying to achieve full employment remains the same even in an open economy. Governments must attempt to adjust spending so that the deficit compensates (as perfectly as possible) the sum of desired private sector surplus and the trade deficit in order to avoid GDP fluctuations. Independently of their causes (changes in foreign spending behavior or changes in domestic spending behavior), shifts in the [Private Sector Surplus + Trade Deficit] curve will not cause GDP fluctuations unless governments fail to adjust their deficits accordingly – i.e. unless the GSFB curve is vertical. Sincerely, Daniel Negreiros Conceição

  4. You should note that although the public deficit in the SHORT term manages to avoid a catastrophic collapse in demand , the new equilibrium point is at a lower GDP with a constant supply of public debt (which by itself is unsustainable unless something moves the equilibrium back to full employment). In other words , Krugman praises the worst of all worlds : Keynesian deficit and equilibrium below the potential GDP. Brilliant , isn´t it ?

  5. Hi DanielCompletely agree. I didn't mean to imply that had left anything out . . . made that same mistake with Bill's post on an earlier version . . . I was mostly trying to point out that the results are unchanged, as you've noted.Also . . . yes, the dichotomy we always use is government sector vs. non-government sector, and the latter includes the current account balance.My use of the PFSB vs. the CAB+Gov Def line was based on 2 reasons (by the way, CAB is a much better term than I was using):1. We mostly care about the outcomes for the domestic private sector in terms of net borrowing/saving (a la Minsky). The government deficit is a residual. It's also not hard to use a CAB and Gov Def graph to show how the CAB+gov def line is evolving on its own.2. The PSFB line is upward sloping and the CAB line is downward sloping, so it seemed more intuitive to split those up. Indeed, depending on the country, it's unclear whether a PSFB+CAB line would be upward or downward sloping, and would likely be different for different countries.As you note, it really doesn't matter overall . . . both are equivalent. Very nice piece!!Best,Scott

  6. Dear Anonymous,The reason for aggregate incomes and aggregate production to fall as the result of changing spending propensities by the non-government sectors (as is the case in our current recession) is exactly the fact that the proposed policy goal of a vertical GSFB curve has not been achieved. My argument is that a vertical GSFB curve is the optimal case. Note that a steeper curve means a more responsive (i.e. more counter cyclical) government deficit. The deficit will remain at any given level just for as long as the gap between GDP at full employment and non-government sector spending remains fixed. Therefore, in the case of a vertical GSFB curve the “supply of government debt” will remain at the level demanded by the non-government sector and it will not be “constant” unless non-government spending propensities remain fixed. In fact, a constant supply of public debt would be observed if the GSFB curve were horizontal, not vertical. It follows from this that relatively flatter GSFB curves describe sets of policy instruments less adaptive to changes in economic circumstances. One can look at the steepness of the GSFB curve as showing the government’s promptness to deal with changing economic environments and avoid fluctuations of income away from the level associated with full employment. Would the government’s behavior described above generate unsustainable conditions? I do not believe it would. Here are some reasons why. First of all, a vertical GSFB curve describes a government that has found the perfect set of counter cyclical policies so that reductions (increments) in spending by the non-government sector are perfectly offset by increases (reductions) in the government deficit so that the economy remains at full employment GDP despite demand shocks. Therefore, by definition the government deficit/surplus cannot be too large or too small. It is just right given the state of non-government spending. In other words, the proposed policy goal is designed exactly to maintain the economy operating at full capacity, not above it and not below it. Therefore, by definition the proposed policy goal does not face supply constraints that may threaten its sustainability. It simply guarantees that there will be no unnecessary underutilization of the economy’s resources. One could be tempted to denounce the proposed policy goal as not being financially sustainable. First of all, it has not been advocated here that governments should sustain any given level of deficit. What has been proposed is that governments can avoid GDP fluctuations by accommodating changes in desired non-government sector positive balances by allowing its financial balances to adjust accordingly. During “good” times, when the non-government spending propensity is relatively high this policy goal may be achieved with a relatively small government deficit. For net exporting countries, the policy goal may be achieved without government deficits or even with temporary small government surpluses. It is mostly during moments when non-government spending falls drastically that the government deficit will be expected to be relatively large.

  7. Continuing…Nonetheless, even if the policy goal of maintaining GDP at the level associated with full employment requires prolonged large government deficits, the situation is always financially sustainable. The risk of inflation has already been dismissed since we have shown that one of the effects of a vertical GSFB curve is to keep aggregate spending from rising above the level of GDP associated with full employment. In other words, the deficit can never be too large. But can governments always meet debt obligations if the deficit remains persistently large? As many have demonstrated (including almost all bloggers and commentators who post here more systematically such as L. Randall Wray, Stephanie Kelton, Bill Mitchell and Warren Mosler) before, sovereign governments operating in a floating exchange rate system can always meet any financial obligation denominated in their own domestic currency unless some unjustified fiscal rule has been (self) imposed upon them. Sincerely,Daniel Negreiros Conceição

  8. Dear Scott,Seems we are thinking on almost exactly similar lines. I look forward to having the chance to talk to you in person in the future just to see if we can find some minor reason for disagreement (though this seems unlikely at this point). Thanks for the helpful comments and support,

  9. Dear Daniel, Scott, Rob and Bill,Great stuff but I would suggest calling your lines desired PSB (PSBd) and desired (GSFBd). Reading your post, we are going back to the irrelevant and confusing expost/exante debate. You seem to assume that the sum of the actual balances equals zero only "expost" "at equilibrium" (i.e. after adjustment of income).That is clearly not correct, the accounting identity holds all the time, before, during and after the process. Stated differently, the sum of actual aggregate financial balances always equal zero no matter where GDP is on the horizontal axis. Desired balances may not sum to zero though (which is clearly the case on your graphs).

  10. Hi Eric Agree. I actually wrote in an earlier draft that these were identities, so we are always moving along the curves (shifting one or the other), but I like your suggestion better.And Daniel . . .I'm actually moving toward agreeing with you regarding the best way to draw the graph. Revision of my post potentially coming if I find the time.Best,Scott